4. Ownership
of Product Produced Under a PSA and the Contractor Nature of an Investor Under
a PSA

5. The
Sharing of Product: Substance and Procedure

6. PSA
and Taxation

III.Characteristics Distinguishing a PSA
from Other Forms of Subsoil Use

IV.Conclusion:
Significance of the PSA for the National Economy and the

Protection of the Interests of Investors

I.Introduction:
Historical Background

The first concept for the production
sharing was used in Bolivia in the beginning of the ‘50s.But agreements on production sharing, in
their current form are instruments of legal regulation of relations between a
state and an investor in the sphere of the extraction of useful minerals (in
particular oil) were successfully applied in Indonesia in the 1960s and
gradually recognized by leading international oil & gas companies.

Since those times, PSAs have received wide
applications in countries with economies in transition.PSAs as a form of cooperation between an
investor and a state in the process of the use of the subsoil now actively is
used in more than 40 countries, including Angola, Vietnam, Libya, Egypt,
Malaysia, Peru, Syria, the Philippines, Equatorial Guinea and others.In recent years, PSAs have begin to be used
in the CIS: e.g. Russia,Azerbaijan and
Kazakhstan.In 1995, the Russian State
Duma adopted the Federal Law “On Agreements about Production Sharing”, and at
the present time several investors already are conducting their activity in
Russia under PSAs, although this law is not yet being widely applied because of
the lack of subsequent legislation.

II.The
Production Sharing Agreement (“PSA”) Concept

A.General Principles of PSAs

PSA – this is a special form of subsoil use
relations based on civil-legal contractual principles for relations between a
state and an investor with respect to prospecting, exploration and extraction
of mineral resources.

PSA – a contract pursuant to which
the state (owner of the subsoil) entrusts the investor to conduct prospecting,
exploration and extraction of mineral resources within the confines of a
defined subsoil area on a compensated basis and for an established time period
during which the investor is obligated to conduct the indicated work at its own
expense and own risk.

B.Basic Distinguishing Characteristics of
PSAs

The principal distinguishing
characteristics of a PSA from other types of a civil legal agreement are set
forth below.

1.The Subject of a PSA

The subject of the given contract is the agreed
program of the parties for the extraction of mineral resources which must be
fulfilled by the investor in favor of the state.Such program includes the type, costs and period of
performance.In other words, the state has
hired the investor as a contractor to perform the work envisioned by the
program.

As a result, contractual relations arise between two
legally equal parties, each having rights and obligations, the violation of
which shall entail their legal liability.

The State hires the investor as a contractor for the
conduct of work connected with the extraction of useful minerals.At the same time, it takes onto itself the
obligation to transfer to the investor for use the subsoil area specified in
the agreement.In the majority of
countries in the world (including Ukraine), the subsoil belongs to the
state.The state has a monopoly over
the use of the subsoil and the removal from it of natural resources. The
granting to an investorof exclusive
rights denotes that the state during the periodof PSA’s validity, is obligated to abstain on the given subsoil
area from activity included in the volume of the transferred rights and not
permit such activity on the part of third persons. Only the investor may
conduct activity envisioned by the agreement. But this does not mean that the
investor shall obtain unlimited rights. The exclusive rights being transferred
to the investor are limited by: (i) the types of activity envisioned by the
agreement, (ii) the types of minerals indicated in the agreement, and (iii) the
terms indicated in the agreement.

2.The
State as a Party to a PSA

A PSA as a civil-law agreement is
concluded between legally equal parties: the state and an investor.All conditions for use of the subsoil and
the performance of work is established by the parties by mutual agreement.

Nonetheless, one has to take into
account that the state participating in the agreement preserves its state
prerogatives.Therefore in relations
for subsoil use arising on the basis of a PSA, the state acts in two roles: on
the one hand it fulfills its obligations under the agreement, and on the other
hand it preserves its state public-legal functions.These roles may converge or come into conflict with each other.
In their delineation, one should be guided by the following principle: within
the scope of conditions provided by the agreement, the state and the investor
are equal partners, outside such scope - the state makes decisions related to
subsoil use on an authoritative, administrative-law basis.

3.The
Activity of an Investor at its Own Expense and Risk

The investor
carries out the activities envisioned in the agreement (prospecting, search,
exploration, extraction and other works) at its own expense and risk. The
state, as the other party to the agreement does not bear any expenses or risks.
If the investor invests funds in the prospecting and exploration but did not
discover any minerals, or discovered that their extraction would be
economically unprofitable, the expended funds shall not be refunded to the
investor. This is a basic principle of a PSA. The parties, however, may agree
otherwise.

4.Ownership
of Product Produced under a PSA and the Contractor Nature of an Investor under
a PSA

Under a PSA,
the state transfers to the investor only exclusive rights to conduct activity
involving a subsoil area, but does not transfer rights to such subsoil area
into either ownership or lease. Therefore, all extracted minerals or extracted
and processed minerals (i.e., the produced product) are the property of the
state. The state hires the investor as a contractor to perform work for it, but
at the expense and risk of the investor. The work is carried out on a
compensated basis, with the state paying the investor not in money, but with a
portion of the produced product. This is the so-called production sharing,
i.e., the sharing of the results of the work carried out by the investor.

5.The
Sharing of Product: Substance and Procedure

Production
sharing is the central part and the main distinguishing characteristic of a
PSA. This principle actually gave the agreement its name.

In order to determine the volume of the extracted
raw materials and to carry out production sharing, the concept of the “point of
measurement” is used - an arbitrary point related to the movement of extracted
raw materials specified by the parties in the agreement (the mouth of the
shaft, the delivery point, etc.). At the point of measurement all the raw
materials being extracted is the property of the state. The production sharing
is also carried out at the same point and usually follows the following
procedure:

nfrom the product produced by
the investor is separated that part that goes toward the compensation of the
investor’s expenditures (cost-recovery product);

nthat part of the produced
product that remains (profit product) is divided between the investor and the
state in a proportion provided in the PSA.

From the time of production sharing at the
measurement point the investor has the right of ownership to the cost-recovery
product and its part of the profit production.

The conditions for
production sharing between the state and the investor are determined in each
specific agreement.

As a result of the
production sharing, the state, without investing its own funds into the
prospecting, exploration and extraction of mineral resources and without
bearing any commercial risks, receives a substantial part of the product
produced by the investor.Instead of
the product, the investor may transfer to the state its value.

6.PSA and Taxation

During activities on the
basis of a PSA, a special tax regime is used for the investor. Within the time
period of validity of the PSA, the existing state taxes and other mandatory
payments are replaced by a part of the profit product. They are taken into
consideration while drafting an agreement to determine the part of the product
produced by the investor which remains in the ownership of the state.
Apparently, no tax privileges are granted to investors. The existing tax system
is simply replaced by production sharing in the case of the use of a PSA.

Production sharing between the state and the investor is carried out on
the basis of principles determined in each specific agreement.

There
are two known systems for replacement of taxation by production sharing:

ncomplete replacement of
taxes by a part of profit product (for example, in Libya, the state divided the
produced products between itself and the investor in the proportion 81:19 without
levying any taxes or fees);

npartial replacement, when
simultaneously with production sharing is envisioned the levying of certain
taxes (for example, in Russia profit tax and fees for subsoil use are levied,
and in Indonesia - income tax and a divident taxare imposed).

Therefore,
the PSA concept, on the one hand, protects the interests of the state, and on
the other - makes the investor immune from the changing tax policy of the
state.Production sharing creates a new
procedure for subsoil use, as an alternative to the conventional tax system, in
accordance with which individual characteristics of subsoil use are taken into
account on a contractual basis in each PSA.

III.Characteristics
Distinguishing a PSA from Other Forms of Subsoil Use

In the
world practice, the concession and licensing forms of subsoil use are widely
used.

A
concession is a civil agreement under which the state provides on a compensated
basis and the investor purchases the exclusive right to the use of a subsoil
area for agreed-upon purposes, in particular, for prospecting, exploration and
extraction of useful minerals, bears all expenses and risks, as well as makes
payments to the state for the use of the subsoil and for all other taxes and
mandatory payments envisioned by law.A
concession by its legal nature is a type of a lease agreement.

The
licensing system of subsoil use is by its nature administrative-authoritative.
Under the licensing system, the investor also purchases from the state the
exclusive right to use a subsoil area for the extraction of useful minerals.
The investor is also the owner of the extracted raw materials, bears all
expenses and risks, makes payments to the state for the use of the subsoil and
all other taxes and fees envisioned by law, but the state structures its
relations with the investor on an authoritative, administrative- managerial
basis.By granting a license, the state
by its authoritative act permits the investor to use the subsoil on conditions
established by the state unilaterally.In the same manner, the state may withdraw its decisions, limit the
rights of the investor or completely withdraw the investor’s rights and revoke
the license.

Under
a PSA the relations between the state and the investor are contractual, that is
formally equal.In the agreement
itself, the parties define conditions governing the transfer of subsoil for
use. The produced product is the property of the state, and after production
sharing at the measurement point, a certain part of it is transferred to the
ownership of the investor.A PSA is a
type of contract where the right of ownership belongs to the customer [i.e. the
state], and the contractor receives compensation for the performed work.

In
this case the tax system envisioned by law is replaced by a special new system
of settlements between the parties - production sharing.

When
subsoil is used under a PSA, a license issued by the relevant body of the state
is also needed.But its role is
different. The rights and responsibilities of the parties are determined in the
agreement itself, while the license only exists for purposes of formalizing and
registration when a right to use the subsoil arises.

IV.Conclusions

It
follows that in the environment of a transitional economy and changing legislation,
subsoil use under PSAs is desirable both for the state and the investor. It is
desirable for the state because:

nattracting substantial
volumes of investment, including foreign, to the exploration and extraction of
useful minerals is important not only for the stable functioning of the economy
but also for ensuring the national security of the country by means of reducing
dependency on energy imports;

nexploration and extraction
of useful minerals demands less material-financial resources which the state
does not have. The necessary resources are contributed by the investor;

nthe state has the
opportunity to conclude long-term agreements with investors on the basis of
which it can calculate future growth in the extraction of oil, gas and other
useful minerals, as well as budget income;

ninstead of tax payments,
which as practice shows are often difficult to collect, the state receives a
certain fixed part of the extracted product.

It is also desirable for the
investor to invest under a PSA, because it gives such investor a greater degree
of independence from the constantly changing tax system. The relations of the
investor with the state under a PSA are in large part structured on a
civil-legal basis. Of particular importance to the investor is the stability of
legal relations between the state and itself in the time-period of validity of
the agreement.